The Office of Fair Trading should investigate the recent trend of councils producing their own local newspapers, according to a committee of MPs that accuses some authorities of using public cash to finance publications that are little more than political propaganda.

In a report published today, the culture, media and sport committee also warns that the provision of regional news on ITV1 is reaching a "crisis point" and cash from the TV licence fee should be used to ensure that the BBC continues to face competition in the regions.

The 85-page report also recommends that restrictions be lifted on local and regional media groups so they can merge – creating more viable long-term businesses – and work together to take on the might of Google News without being accused of anti-competitive collusion.

The committee does not believe that Google is abusing its position as a dominant online player, but it stresses that the search engine giant is "having a significant impact on traditional publishers' economic models… and hope[s] Google is sensitive to the need to maintain diverse, pluralistic sources of local news and information".

The committee's chairman, John Whittingdale, the Conservative MP for Maldon and East Chelmsford, said local media performed a vital function "yet local media face unprecedented challenges as a result of structural changes and the impact of a global recession. This has led to the closure of a large number of newspapers, many commercial radio stations becoming loss-making and the possible end of regional news on commercial television. This has serious implications for local democracy."

During its investigation the committee heard from a stream of media executives who complained that local authorities were hastening the demise of independent local newspapers by funding their own competing publications that were little more than council propaganda.

The government's own Digital Britain report, published last June, concluded that while they could be useful for local residents and businesses, council-funded papers would inevitably not be as rigorous in holding local institutions to account as independent local media. As a result, the government asked the Audit Commission to investigate whether restraints should be placed on local authorities.

In January the commission said local authorities were not wasting public money. The culture, media and sport committee, however, strongly disagrees.

"There is a real problem with local authority newspapers and magazines that needs to be addressed," according to the committee's report. "While it is clear that most of these publications, such as Portsmouth city council's Flagship, are legitimate communications from a council to its citizens, this cannot be said for all local authority publications."

"Publications such as Hammersmith and Fulham borough council's H&F News effectively pose as, and compete with, local commercial newspapers and are misleading to the public. It is unacceptable that a local authority can set up a newspaper in direct competition to the local commercial newspaper in this way. Nor should any council publication be a vehicle for political propaganda."

The report accuses some councils of breaching the Department for Communities and Local Government code of practice and recommends that the ministry set up a system to monitor the situation and tighten the rules so that councils must make clear – not only on the front page but throughout the newspaper – that they are local authority publications.

The Audit Commission's review of council publications did not examine their impact on commercial titles, so the committee's report recommends that "the Office of Fair Trading should conduct a review specifically on" that impact.The committee also fears that regional news could vanish from ITV1 altogether, as the broadcaster has made it clear in the past that it does not intend to produce regional news once the switch to digital TV is concluded in 2012 – although this is being reviewed by the new chairman, Archie Norman. The MPs want ITV to be relieved of its public service broadcasting obligations and other regulatory burdens as soon as possible in order to alleviate the financial pressure it is under and allow regional news to continue.

The government has suggested that part of the TV licence fee could be used for independently funded news consortia (IFNCs) in England, Scotland and Wales that would continue to provide local news. However, the shadow culture secretary, Jeremy Hunt, said in January that "using the licence fee to prop up regional news simply casts a failed regional TV model in aspic".

The Conservatives want restrictions on local media ownership dumped so that local news groups can consolidate, which the committee backs. But the report welcomes the IFNC plan, while noting that "given the lack of cross-party support for IFNCs, their future is highly uncertain".

Whittingdale said: "The position of regional news on Channel 3 is deeply worrying. The plurality of regional news on television is of upmost importance and needs to be protected. It is not acceptable for the public to become reliant solely on the BBC for regional television news.

"The proposals for independently funded news consortia offer one solution, but their future is far from certain. In the meantime, to sustain regional news on ITV, the financial burdens created by ITV's public service obligations and other regulations should be lifted."

As well as loosening the rules surrounding local and regional news ownership, the committee's report also supports proposals from Ofcom for deregulation of cross-media ownership so that local radio can be included in consolidation.

Finally, the committee heard from several media executives about the problem posed by Google as they attempt to follow their audience online. The Trinity Mirror chief executive, Sly Bailey, referred to "the super-dominant position of Google and Google News" and told the committee: "They [Google] do not spend a penny on any kind of journalism at all and yet they are making money out of our journalism."

Carolyn McCall, the outgoing chief executive of Guardian Media Group, referred to it as a "no win" situation, with newspapers unable to remove their content from Google as this it be even more damaging to their businesses. She complained that local media groups were unable to band together to deal with the threat of Google because that would be seen as "collusion".

"We as publishers cannot sit down in a room together and talk about the issue of [online content] aggregators. We cannot sit down and say, 'What can we do about this? Can we go together to Google?' We would be in collusion so therefore as individual players we have to think about this or come to select committees like this and say, 'This is a really big issue.' We cannot sit in a room, even with lawyers, and do this because it would be deemed anticompetitive," McCall told the committee.

Late last year Google introduced new features designed to alleviate the concerns of publishers – including a limit on the number of free articles readers can access through Google News and a new online newspaper publishing service – and the committee's report welcomes these changes. But it also wants the OFT to look at the issue of collective bargaining.